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Business News/ Opinion / Time for new ideas in the euro zone
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Time for new ideas in the euro zone

Time for new ideas in the euro zone

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The idea of a common European identity has captured the imagination of Europeans for nearly four decades after World War II, which culminated in the Maastricht treaty in 1992 where the rules of the game for participation in the euro zone were laid out.

These rules required participating countries to surrender their power to print currency and set monetary policy and moved under the aegis of a European central bank and a common currency. They effectively gave up two of the three levers that governments use to manage economies. The only lever left related to the ability to manage fiscal policy.

This economic experiment was questioned by economists, including Milton Friedman, who wondered if it was possible for countries that were politically separate to operate within a framework where they lost their currency and monetary sovereignty. These fiscal choices have side effects, which can only be mitigated by managing the currency or the interest rate. If countries did not have these tools at their disposal, fiscal imbalances could persist till a point when they became unmanageable. It was expected that many nations would not be able to meet the strict fiscal tests demanded for entry into the European Union (EU). Surprisingly, many nations did manage to enter the EU and seemed able to pass these fiscal examinations successfully.

Also Read Govind Sankaranarayanan’s earlier columns

Then came the recent problem with Greece, which announced that it had a fiscal deficit of 12%, way beyond the EU norm of 3%, and also higher than what it had been disclosing to the EU in the recent past. It has also indicated that it is likely to default on between $20 billion (Rs90,200 crore) and $50 billion of debt due for repayment in the next few months and has sought a bailout from its sister EU countries.

Politicians in many countries, notably France and Germany, have wondered why, in the middle of a downturn with unemployment in the euro zone running at nearly 9% and with real gross domestic product (GDP) not growing, they should subsidize Greek profligacy.

The Greek government has taken several strong and politically unpopular measures to extricate itself from the situation. The sheer size of the deficit is so large that it is likely to take several years before Greece is able to resolve its problems. Unemployment in the so-called PIIGS (Portugal, Italy, Ireland, Greece and Spain) countries varies between 9% in Italy and 19% in Spain.

It would appear that some of the ideologies that drove the creation of the euro zone were influenced strongly by their experience of slow growth and high inflation periods in the 1970s and 1980s. At its heart is a strong belief in monetarism which suggests that price stability and control of money supply is the primary economic goal of a country. Since under the European system this could only have been followed in conjunction with a very rigid fiscal policy, there were strictly binding limits on budget deficits and debt.

Is this kind of structure relevant today? At the time the EU was created, did its framers recognize a world where large numbers of highly competitive new economies with billions of people and growing at rates of 10% per year would dominate the market?

European countries are not a single monolithic block. There are significant variations in economic infrastructure, labour productivity and cultural factors. Faced with a New World order, countries will normally want to respond in different ways. Some will choose to devalue their currency to compensate for high cost structures in their country and still be competitive. Others might choose strict fiscal policies which keep deficits under control and manage their currency tightly.

In the volatile, competitive world of the last 20 years, countries need to have in their armoury a far wider range of policy responses. They then need to have the flexibility to use the right tools at the right time. The structure of the euro area does not appear to permit this. It is not surprising that with few exceptions, GDP and competitiveness in the euro area has been lower than in some other parts of the world.

There is, therefore, a need for more fundamental change within the thinking in the euro zone. European countries need policies that will focus on inspiring growth in today’s competitive market, rather than the current focus on controlling prices. The recently proposed European monetary fund that countries can turn to when they are in trouble is perhaps one step in this direction.

Given that the troubled European countries in question account for nearly 35% of the euro area’s GDP and approximately 5% of the world GDP, there is enough at stake for bureaucrats in Brussels to reconsider whether the straitjacket of their economic policies is suited for the 21st century

Govind Sankaranarayanan is chief financial officer, Tata Capital Ltd. He writes on issues related to governance. The views expressed in this column are personal. Write to him at ruleofthumb@livemint.com.

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Published: 01 Apr 2010, 09:34 PM IST
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